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October 23, 2007

Putin to Remain Front and Center in Russia

Economic policies meet with overwhelming approval

Vladimir Putin, the former KGB agent who succeeded Boris Yeltsin as president of Russia in 2000, has said he may place himself at the mercy of the Russian electorate after his presidential term expires next year, and stand for prime minister on the United Russia slate.

Russia has enjoyed unprecedented economic growth over the seven years of Putin's reign, due largely to surging oil and gas export revenues. One could argue Russia deserves a break, after 370 years beneath the czars, 74 beneath the Bolsheviks, and the chaos, corruption, and near-collapse of the perestroika and Yeltsin years. At any rate, the commodity price surge jump-started the economy--as well as the government to repay its international debts--leaving the ruble devaluation, debt default, and financial crises of 1998 far behind.

And of equal if not greater importance, Putin has re-introduced stability to Russia--largely by following the czarist and commissar model of concentrating significant power in his own hands.

All of this has met with the overwhelming support of Russian masses. His current approval rating is around 82%, according to the Russian Public Opinion Research Center. "It should come as no surprise that Putin will try to keep his grip on Russia's reins after his second term as president ends in early 2008," says Julian Mayo, investment director at London-based Charlemagne Capital, a money manager specializing in emerging markets, who says the prospective prime-minister bid is merely one of many possible ways Putin will seek to hold onto influence after stepping down as president.

Mayo describes Putin's plan as "positive" for the Russian economy in that it reduces uncertainty.

John Connor, portfolio manager of the Third Millennium Russia Fund (TMRFX), one of the few all-Russia investment vehicles available to U.S. investors, says Putin installed a team of "excellent economic advisors who managed a very conservative and successful fiscal program." It has built up huge surpluses, Connor says, both budgetary and trade, resulting in reserves that rank just behind Japan and China. GDP, which grew by about 6.7% last year, appears set to grow 7% to 8% annually over the next several years. Russia -- now the world's tenth largest economy - should ascent to fifth place by the middle of the next decade, Connor thinks.

Borge Endresen, portfolio manager of the AIM Developing Markets Fund (GTDDX), offers a dissenting view. Putin, he says, has benefited from a confluence of benevolent factors outside of his control.

"Russia's main export--oil--went from roughly $25 per barrel of oil equivalent (boe) when he was first elected in mid-2000 to about $80/barrel today," Endresen says. "Russia remains primarily a commodity exporter and it has benefited from price surges practically across the entire range."

Indeed, any discussion of the Russian economy invariably focuses upon its dominant energy sector. Russia possesses the world's largest known natural gas reserves (with Western Europe as its biggest customer), and is second only to Saudi Arabia in oil production.

But Connor does not see much growth coming from Russia's oil and gas sector. The Third Millennium fund only has a 13.3% allocation to energy stocks (down from 50% last year). Connor explains that despite elevated crude prices, Russian oil stocks will remain under pressure since their revenues are dollar-denominated amidst an environment of a strengthening ruble and faltering dollar.

The Russian government also imposes a heavy tax burden on its energy companies, Connor notes, although these are likely to be relaxed after next year's elections.

Endresen says Russian economic growth "most likely would have been even higher without Putin, as many energy producers in particular curtailed investments after he imposed massive tax increases." These tax hikes also account for a dramatic fall-off in production growth over the past few years, Endresen says.

Nevertheless, Connor believes that Russian voters, as well as foreign investors, will likely cheer a triumph by Putin's party in next year's election, and embrace his continuing presence at the center of Kremlin politics.

One of the keys to understanding the enormous changes in Russia is the country's large and growing middle class, Connor says. "The middle class will represent 50% of the total population within a few years, from a level of about 25% now. They form the bedrock of Putin's popular support. Their wages are rising--disposable income for the average Russian worker is expanding 26% annually--which translates into higher consumer spending and robust domestic markets."

As an investment theme, Connor suggests that investors look at the growth of Russia's consumer sector and the government's plan to spend up to $1 trillion on upgrading the nation's dilapidated infrastructure. The government established a "Stabilization Fund" (now totaling in excess of $141 billion), which is designed to safeguard the Russian budget against any abrupt decline in oil prices. Cash from this fund will likely be spent on improving roads, ports, railways, building energy pipelines, and increasing pensions for citizens.

Despite Russia's buoyant economy, Putin has come under some severe criticism, both abroad and at home. Some liberals are uncomfortable with his KGB background, his domination of the media, and his rather undemocratic stifling of dissenting views.

Garry Kasparov, the famous former world chess champion who entered Russia's presidential race as a candidate for the "Other Russia" opposition party--a coalition of anti-Putin forces which includes both left and right-wing elements--has led the charge of attacks against Putin. Reflecting his fears that Putin represents a threat to democracy and civil liberties in Russia, Kasparov recently told a Capitol Hill briefing, "We are not fighting to win elections. We're fighting to have elections." (On October 11, Kasparov's party was barred from taking part in the December parliamentary polls by the election commission because Other Russia is not registered as a political party.)

Russia also faces other serious problems that threaten both its stability and future economic growth. Since the fall of the Soviet Union, the birth rate and life expectancy of males has declined, leading to the prospect of negative population growth over the next decade. According to Russia's health ministry, the average life expectancy for Russian men is now below 60, comparable to Pakistan, and about 15 years lower than in most other industrialized nations. The U.N. also predicts that Russia's population will decline from 146-million today to between 80 and 100 million by 2050.

Russia's social structure is also threatened by high rates of alcoholism and the growing incidence of HIV infection. "They are facing a demographic disaster," Connor says. "And it will have long-term implications for their economy." Investors seeking exposure to Russia must remember that despite the tremendous advances it has made in recent years, it remains an emerging market, with the attendant risks. Russia accounts for 9% of the MSCI Emerging Markets Index.

The RTS Index has risen 14.6% this year through October 11 (in local currency), following a 48.0% surge in calendar 2006. But Russian equities remain relatively cheap. According to S&P/Citigroup Global Equity Indices, Russian stocks traded at a forward 12-month P/E ratio of just 11.8 (as of September 28, 2007), vs. 14.4 for the emerging markets as a whole.

S&P international equity strategist Alec Young currently favors other emerging markets like China, India, and Brazil, since the consensus earnings growth forecast for Russia in 2008 is only 6%, versus strong double-digit gains for these other countries.

While many observers would point to falling crude oil price as the major risk to Russia's economy, Mayo points out that Russia is one of the few countries with a fiscal surplus and which can weather a global economic downturn better than virtually any other country, even if the price oil plunges to the $50 to $60 level.

"The Russian market has been held back by political uncertainty, but now that Putin has showed his hand, this is largely removed," Mayo says. "Having more detail on Putin's post-presidency intentions removes a degree of uncertainty surrounding Russia's economic future."